Finance: Research, Policy and Anecdotes

Making Basel III work for the emerging world

As I have mentioned in a previous blog entry, I have been co-leading a taskforce on Making Basel III Work for Emerging Markets
and Developing Economies (EMDEs). The report was formally launched at a G-24 meeting during the Spring Meetings in Washington DC and is now
available, with another blog entry by Liliana and me.

I will not repeat the blog entry or executive summary here,
just point to some of the main messages:

Our conceptual framework starts from specific characteristics of EMDEs that, while not universal, have been widely documented: variable access conditions to international capital markets; high macroeconomic
and financial volatility; less developed domestic financial markets; limited transparency and data availability; and capacity, institutional, and governance challenges.

These characteristics help explain why the impact of regulatory reforms,
such as those under Basel III, is expected to be different in EMDEs than in advanced countries. They also imply the need for a differentiated approach to bank regulation to make Basel III work in these countries and lead us to the following principles underpinning
our recommendations:

These principles have guided our analysis and have led us to certain recommendations, of which I will highlight a few:

Minimizing Potential Spillovers on EMDEs: One
important area of concern are the significant changes in the volume and composition of cross-border financing to EMDEs since the Global Financial Crisis, including a reduction in cross-border lending from global banks, a heavier reliance by EMDEs on debt issues
rather than cross-border lending, and an increasing role of South-South lending. These three developments have important policy implications, but also call for more analysis than before, undertaken by central banks and regulators in advanced countries and
EMDEs as well as by international institutions.

One specific area of concern in this context is infrastructure finance. While far from clear that Basel III has been a primary factor behind the relative reduction in private
infrastructure finance in EMDEs, an ongoing challenge is that infrastructure is currently not an asset class in itself. If projects can be developed in a more standardized fashion and there is agreement on the different dimensions of risk and how they should
be quantified, then it may become easier to issue securities backed by infrastructure projects.

Another area of concern (that pre-dates Basel III) is the potential for spillover effects through the large presence of subsidiaries
of global banks in EMDEs. Home supervisors in advanced economies require that regulations, including Basel III, be applied and enforced on a consolidated basis, that is including its foreign affiliates. But this can mean that the same sovereign exposure
might get different regulatory treatment by home-country than by host-country supervisors. Currently, for example, in calculating capital requirements, most EMDE authorities assign a risk weight of zero to papers issued by their sovereign and denominated in
local currency, whereas global banks largely use their own internal rating models for this purpose. Thus, it is plausible that the same sovereign paper issued by an EMDE government could be treated as a foreign currency-denominated asset, with higher risk
weight requirements, if held by a local subsidiary of a global bank. This, in turn, increases the cost to the subsidiary to hold the sovereign paper and might increase the financing costs of EMDE governments. One possible solution would be to agree on threshold
values for a set of easily verifiable and widely available macrofinancial indicators (including, but not limited to, international credit ratings). For host countries whose indicators surpass the thresholds, home-country supervisors and global banks would
accept, at the consolidated level, the host country’s regulatory treatment of these exposures

Aiming for Proportionality: As EMDEs proceed to adopt and implement Basel III in their countries, proportionality
implies adjusting capital and liquidity requirements to the capacities and needs in EMDEs. Many emerging markets “gold-plate” capital requirements, increasing them beyond international standards to reflect higher risks. It might be better to use
a data-driven process to determine the riskiness of assets and thus the necessary capital buffers. Where available, micro-data can be used to calibrate risk weights to the realities and stability needs of emerging markets. When it comes to liquidity
requirements, simpler ratios might be called for if the data requirements for the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) are not easily fulfilled. On the other hand, the typical characteristics of EMDEs, as discussed above,
might make a centralized, systemic liquidity management tool necessary. Specifically, banks could be mandated to maintain a fraction of the liquid assets required to fulfil Basel III requirements with a centralized custodian such as the central bank.

Minimizing Trade-offs between Financial Stability and Development: While the financial stability goal in Basel III is necessary, the growth benefits from deeper and more efficient financial systems are larger in emerging than in advanced
markets. And when banks are – correctly – subject to increasingly tighter regulatory standards, there is a bigger premium on developing non-bank segments of the financial system, such as insurance companies, pension funds, and public capital markets
– segments that are still underdeveloped in most developing economies.

As happy as I am to have finalised this report, the launch of the report is not the end of the work! I will be presenting the report at an IMF/BIS conference
in May and at a conference of the Community of African Bank Supervisors in June. Stay tuned for a follow-up.